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The First Victims Of The Oil Price War

As the oil price war and coronavirus pandemic rage on, it’s becoming increasingly clear that the energy market can remain choppy and irrational longer than entire nations can stay solvent. Everybody is watching to see which of the leading protagonists between Saudi Arabia and Russia is going to be the first to blink as high supply and low demand threaten to overwhelm available storage facilities. Scores of oil-producing countries have adopted a raft of austerity measures and spending cuts as they attempt to outlive the biggest oil bust in living memory.

Unfortunately, it’s the riskier corners of the global financial markets that will emerge as collateral damage in the ongoing oil price war.

American credit rating agency Moody’s has warned the dramatic plunge in oil prices is likely to cut fiscal revenue and exports for most exposed oil-exporting sovereigns by more than 10 percent of GDP and, consequently, weaken their credit profiles.

Russia: Most Resilient

According to Moody’s, the sovereigns most vulnerable to low oil prices in the 2020-21 period are those with the highest reliance on hydrocarbons for fiscal exports and revenues coupled with a limited capacity to adjust.

The credit agency says the most vulnerable sovereigns are Oman, Iraq, Bahrain, and Angola due to their limited capacity to adjust to external shocks. These nations could see a decline in fiscal revenue in the range of 4-8 percent of GDP if low oil prices persist.

The vast majority of Gulf Arab states are unable to balance their budgets with oil prices of $40 per barrel, let alone the current $20/barrel level. These developing economies are especially vulnerable due to ongoing massive cash outflows, with investors continuing to liquidate emerging-market assets.

In contrast, Russia, Saudi Arabia, Qatar, Azerbaijan, and Kazakhstan are seen as being less vulnerable, with expected declines in fiscal revenue and exports of less than 3% of GDP.

Moody’s sees Russia as being less vulnerable to external shocks and turbulence in energy markets than most oil-exporting nations due to its massive forex reserves as well as a flexible exchange rate.

Indeed, the lifting cost per barrel of oil equivalent for Russia’s largest oil producer, Rosneft, is now lower than the same metric for Saudi Arabia’s oil giant, Aramco - thanks mainly to a weaker ruble.

The ruble has weakened about 15 percent against the U.S. dollar over the past 30 days, recently hitting a four-year low against the greenback after the oil markets imploded. Russia, though, says it’s quite happy with oil prices in the range of $25 to $30 per barrel and can hold out at these levels for 6-10 years.

One of the key factors working in Russia’s favor is a flexible exchange rate that allows its oil companies to collect revenues in dollars but pay their own expenses in rubles. A weakening ruble vs. the dollar can mean considerable margin expansion for Russian energy firms, as evidenced by Rosneft’s average lifting cost, which has fallen from $3.10 per barrel of oil equivalent last year to just $2.50 currently.

That’s even cheaper than Saudi Aramco’s figure, which has remained in the $2.50-2.80 range.

That’s the case because Saudi Arabia’s currency, the riyal, is pegged to the dollar at a fixed exchange rate. This means that the dollar costs for Saudi Aramco have remained roughly the same even after the oil price collapse.

By the same token, oil producers like Nigeria that defend a fixed exchange rate are likely to feel the heat more. The Nigerian government imposed currency controls to stem dollar outflows during the 2016 oil bust. Unfortunately, this has not stopped reports of a shortage of dollars in the giant African producer just weeks into the oil price war.

Can U.S. Shale Survive?

The U.S. shale oil and gas industry was facing an uncertain future long before the oil price war and consequent market crash thanks to burgeoning supplies, lackluster prices, increasing competition from renewable energy, and dwindling capital that pushed a record number of companies into bankruptcy.

As with the last oil bust, only the most robust, best-financed, and most efficient shale companies are likely to survive if prices remain depressed over a long period, once again reshaping an industry into one that is leaner and smaller. Pundits have already warned of a fresh wave of defaults and Chapter 11 bankruptcies this year, with oilfield services companies seen as being especially vulnerable. Dozens of shale companies have started idling rigs in the Permian while scores have announced dramatic cuts in shareholders programs, including share buybacks and dividends.

Despite the neverending turmoil, the U.S. shale sector is likely to survive the latest bust thanks to oil demand, which is expected to continue growing over the long term.

Consolidation and bankruptcy are actually good things for the bloated industry because it will help pool resources among the stronger remaining players, thus making for a more resilient sector in the coming years.

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The biggest loser in the current situation is the global economy and within the global economy the two largest losers will be Saudi Arabia and the US shale oil industry.

Despite the bravado, Saudi Arabia can neither win a price war with Russia nor is able to flood the global oil market with oil for the following reasons.

The first reason is that Russia’s economy can live with an oil price of $25 a barrel for years compared with $85-$91for Saudi Arabia’s. Moreover, Russia’s economy is highly advanced and well diversified compared with Saudi Arabia’s overwhelmingly dependence on the oil revenues.

The second reason is that Saudi Arabia doesn’t have the production capacity to flood the global oil market with oil. Saudi Arabia is threatening to flood the market with oil in early May by raising its oil exports from the current 7 millon barrels a day (mbd) to 10.6 mbd. However, to raise its oil exports to 10.6 mbd, Saudi Arabia must produce 13.00 mbd including 3.7 mbd for domestic consumption. But it has never ever had such a production capacity and will never ever achieve one. So the talk about raising its exports to 10.6 mbd is a farce. Its production peaked at 9.65 mbd in 2005 and has been in decline since. Saudi Arabia can at best produce some 8.0-9.0 mbd with another 700,000 b/d to 1.0 mbd coming from storage. This is so because its current production comes from five giant but aging and fast-depleting oilfields discovered more than 70 years ago.

The third reason is that the lifting cost per barrel of Russia’s largest oil producer, Rosneft, is now lower than that of Saudi Aramco. This is due to the falling ruble against the dollar. Russian oil companies earn dollars and other hard currencies for their exports but pay for their operations in ruble. The lower the ruble slides against the U.S. dollar, the lower the production costs of Russian oil companies. As a result, Rosneft’s costs per barrel have fallen from $3.1 to $2.5 compared to a $2.80 for Saudi Aramco.

The fourth reason is that President Putin anticipated Saudi Arabia’s reaction to his refusal to agree deeper production cuts by OPEC+ and was prepared for it.

If Saudi Arabia continues with its price war, it will end up sustaining a budget deficit estimated at $116 bn. To this could be added another loss of $200 bn being a 10% devaluation of Saudi Aramco’s shares raising the total to $316 bn. Furthermore, it could end depleting both its sovereign wealth fund and its stored oil and also bankrupting its economy and destabilizing the country.

As for the US shale oil industry, it could emerge from this ordeal leaner with very few drillers who may stay alive slightly longer on a life support machine provided by the Trump administration and bailed out for the time being until its outstanding debts start to mount again.

The industry will be bailed time and again because of its economic and strategic importance to the US economy.

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